HEADED FOR A HARD LANDING?
China’s stock markets – too hot?
By Oliver Jones

On April 11, China’s stock exchanges passed a significant milestone: the combined market capitalization of China’s Shanghai and Shenzhen exchanges overtook Hong Kong’s for the first time. China’s markets have been on a tear since a freeze on A-share listing was lifted last May. Since then, the Shanghai composite index has climbed 135%. Stock market turnover has gone up tenfold. And in the first three weeks of April, three times as many A-share brokerage accounts were opened compared with the whole of 2005.

The market has all the hallmarks of a bubble. What happens if it pops?

Investors got a preview on February 27, and again on April 19, when drops of 9% and 4.5% sent tremors through Asian equity markets (and, to a lesser extent, Western markets). That will happen again if China’s equity prices crash, says Jun Ma, chief economist for greater China at Deutsche Bank. The severity will depend partly on what sparks the correction. If it’s a “blip” – a drop prompted more by rumor than reality – then the impact on overseas markets will be temporary, says Ma. But if the fall reflects true weakness in China’s economy, then the pain in other Asian markets will be deep and lasting. “Depending on the reason and the sustainability of the real economy problem, the impact will be more sustained,” he says.

For China’s individual investors, of course, a market crash could be disastrous. Lacking good investment alternatives, many are betting their life savings on a market with mushy foundations – weak enforcement, little participation from big institutional investors, and opaque financial reporting from many listed companies. Some are even borrowing at high rates to do so.

Still, the Chinese economy would hardly register a correction, says Paul Cavey, chief China economist for Macquarie Bank. “The wealth effect [of a crash] would be limited since less than 10% of financial assets are held in equity.” At the same time, he notes, bank financing is dominant in company funding and thus the drying up of equity financing would have little impact. Ma agrees, although he says that a correction bigger than 20% would hurt China’s manufacturers, which would start to have trouble raising funding for high-return projects and M&A.

A bigger worry, say both economists, is China’s property markets. Chinese
consumers (and many companies) have more of their wealth tied up in property than in equities – a downturn here would have a more direct effect on consumer spending and economic growth. Further, it could be a threat to the financial system: China’s banks have made big loans to property developers. “China’s policy makers are more worried about the property market because more of the banks’ money is at risk,”
says Cavey.

The government is also moving to cool the overheating economy, ordering banks in late April to raise their reserves to 11% of deposits, the seventh such directive in 11 months. Interest rates, last raised on April 28, are expected to continue rising as well. This may pose the biggest danger of all. A miscalculation by communist bureaucrats still struggling to master capitalist ways could spell disaster for the financial and property markets, and everyone else.